The title of his December 15th column was “Asian central banks may spook investors in 2007.”
He mentioned China, India and South Korea. Thailand seems to have beat them all to the punch.
Mukherjee noted that both the RBI (India’s central bank) and the Bank of Korea raised reserve requirements earlier this month – India on local currency deposits, Korea on both won demand deposits and foreign currency borrowing. Higher reserve requirements on foreign currency borrowing are a kind of covert capital control – the Bank of Korea wanted to make it harder for Korean banks to borrow yen or dollars, yen or dollars that the banks then converted to won.
Mukherjee didn’t relate this story to the broader global pattern of capital flows and currency moves – a story discussed exceptionally well by Menzie Chinn and Kash Mansori their Wall Street Journal econoblog. But I will.
I don’t think it is an accident that India, Korea and Thailand have all taken actions to lock up domestic liquidity in the banking system (through higher reserve requirements) and in some cases to try to limit capital flowing into their economies in the month of December.
There was a significant shift in global capital flows in November. Look either at the euro/ dollar -- or the increase in the reserves of Asian central banks. Money that previously flowed to the US – or perhaps Europe – started to flow into Indian markets (especially the equity market), Korean markets and Thai markets.
All faced upward pressure on their currencies. The won and the baht had already appreciated more than other countries in the region – so their exporters in particular worried about further intervention.
And all started to intervene in the foreign currency market in a big way. And intervention isn't --despite what some say -- costless. So called sterilization can be difficult.
But the influx of foreign capital also raised another issue – one that Yu Yongding has raised in the case of China but that applies more generally.
Right now, Asian central banks have to buy dollars for two reasons.
One is that many countries exporters are bringing in more dollars than are needed to pay for their countries imports, so the countries are running current account surpluses. The central bank buys foreign exchange off the exporters to keep the currency from appreciating. The central bank may end up taking a loss on its dollars, but the country’s exporters gain.
The other reason central banks are buying dollars is that foreign investors – whether companies, banks, pension funds or hedge funds – are moving funds into Asia. Those inflows also puts pressure on the currency to appreciate. But when the central bank intervenes, it ends up buying dollars off the hands of foreign investors. And should the central bank end up taking a loss on those dollars, foreign investors gain.
Actually there is a third potential reason why central banks are buying dollars – the local banking system may also be borrowing dollars and bringing the funds into the country. Korean banks reported borrowed $40b abroad in the first 10 months of the year. Some in dollars, but some in yen – borrowing yen to buy higher-yielding won is another form of the carry trade. The local banks are effectively betting against the central bank – they gain if say the won rises and value of their local currency assets increases relative to their foreign currencies liabilities. The central bank, by contrast, loses.
While many Asian countries seem quite keen to subsidize their exporters (or, per Roubini, US consumers), they aren’t so keen to offer the same subsidy to foreign investors (or their own banks). That is why China maintains stiff restrictions on most portfolio flows. And it is the underlying reason why Thailand ended up imposing controls – controls that it partially lifted after the Thai stock market crashed.
Bad – or at best poorly thought through -- policies don’t come out of the ether. Thailand faced a series of real dilemmas.
Let’s look at Thailand’s options.
Thailand could have allowed the recent surge in capital inflows to push the baht up higher. But, well, that would have hurt Thai exports. The baht has already moved by more than the renminbi this year. China’s de facto export subsidies don’t just help the US consumer (and the US treasury, by lowering its borrowing costs); they also hurt all countries whose producers compete with Chinese producers. Lex:
Thailand’s preference for capital controls over more orthodox monetary tools such as lower interest rates suggests an element of panic. This is understandable, since it reflects the policy dilemma faced not just by Thailand, but by all countries trying to compete with China.
That applies to Mexico manufactures and South African textiles as much as Asian electronics and cars. The pressure the RMB peg places on other emerging economies is something I wish defenders of the China’s peg paid a bit more attention to – it doesn’t just impact the US and China.
The Thai central bank could have cut interest rates to make holding baht less attractive – and thus try to discourage foreign capital inflows/ encourage domestic capital outflows. That is one of the responses China adapted to strong capital inflows. But easy money risks fueling a domestic boom – something Mukherjee emphasizes. And sometimes booms lead to bust.
Thailand's central bank could have intervened more. But buying dollars for baht increases Thailand’s money supply. The increase in the money supply could have been offset by an increase in the issuance of sterilization bills. However, heavy sterilization could drive up domestic interest rates. That risks attracting more capital inflows. And higher domestic interest rates obviously cost the central bank money – it ends up paying out more on its liabilities (sterilization bills) than it earns on its assets (US Treasuries).
The Bank of Thailand could have intervened more – and then limited its own sterilization costs by raising reserve requirements. Reserve requirements basically shift the cost of sterilization onto the banking system. They have to lend a large share of their deposits to the central bank at low rates.
Or it could break the link between domestic and international markets with controls. China does that. Thailand tried. But once your financial system is integrated with global markets, suddenly interrupting those links can be costly. Lot of investors put a high premium on liquidity – they don’t want their money tied down and locked into a country.
Thai businessman don’t like the strong baht. But they also don’t like a tanking stock market.
The key point: many Asian countries – Japan – excepted are struggling with many of the same issues facing Thailand.
That includes China. This year it limited the pace of its reserve growth by forcing the banks to hold the money they raised in their IPOs offshore – and perhaps by conducting various swap operations with the banks as well. It also encouraged domestic institutional investors to buy more dollars. But now the banks are taking losses on those dollars. And they aren’t too pleased.
I suspect Chinese state institutions are less inclined to help the PBoC out in 2007 than in 2006. It looks likely that someone in China will need to accumulate $350b or more in foreign assets in 2007 to keep the current system going. Many analysts – including Stephen Green of Standard Chartered – now estimate that China’s current account surplus will come close to $300b in 2007. And China is attracting both net inflows of FDI and some portfolio investment as well. Chinese stocks are booming.
And it seems pretty clear to me that the PBoC isn’t happy adding $250b to its reserves a year – let alone the $350b it may need to buy in 2007. I take the unhappiness of Chinese banks holdings dollars – and the growing complaints from the PBoC about the difficulties with sterilization (see Denise Yam for the details) -- as another sign that Bretton Woods 2 is showing a few more signs of stress now than earlier in the year, or in 2005.
The key question for the stability of the current system of central bank financing of the US isn’t just whether central banks will give out before private markets – something Menzie Chinn noted in the Econoblog. It is also whether central banks will continue to be willing to increase their financing of the US when private demand for US assets falters.
It faltered in November. We are seeing – in my view – some of the consequences of the required increase in central bank intervention now in December.